POLICY IMPLICATIONS
The authors of Lifting All Boats write: "The major features of the [U.S.] legal and regulatory framework governing relationships among owners, institutional investors, and managers have their roots in the political backlash to the stock market crash of 1929." The goal of this backlash was to restore the confidence of the individual investor who, as Berle and Means then said, had recently become the backbone of the market. The sea change in ownership in the last twenty years challenges many of these Depression Era standards and procedures. An emerging new ownership pattern has had and will continue to have a major impact on policy currents. As Black noted in 1991: "A major paradigm shift in corporate law seems to be underway." For Porter and his co-authors the main legal and regulatory goal is balancing liquidity and control:
The key corporate governance challenge we face is whether the concentration of US share ownership in institutions can be harnessed to reproduce the perceived attributes of the continental European and East Asian systems without compromising the unparalleled liquidity and 'efficiency' of our financial markets.
The agenda of most reform proponents is concisely stated by Black:
...we need partly to reduce the legal obstacles that now exist. But we also need to affirmatively encourage voice. We need not just to regulate but to differently regulate--to redefine the role of institutional shareholders so that the institutions will monitor if monitoring is valuable. (emphasis in original)
Below we group the major reform proposal into three main areas:
proposed government regulatory and legal reforms;
proposed corporate and institutional investor reforms which can, on the whole, be undertaken without governmental actions;
a brief section on proposals which do not fit into these first two categories.
Many, but not all, of these policy reforms are directed at minimizing various types of agency problems. It is worth citing Grundfest's note of caution about the inevitable admixture of political and economic events. He writes:
These agency problems would exist even in a purely contractarian state of nature free of any regulatory intervention. But modern corporations do not exist in contractarian states of nature....Accordingly, there is no reason to believe that corporate agency problems can be resolved in an economically rational manner, or that the corporate governance process will, over time, tend toward greater economic efficiency. Instead, the form, nature and severity of corporate agency problems will reflect the push and pull of political considerations as much as the flow of economic events.
Some reform proposals are directed at administrative rulings and interpretations by the SEC and the Department of Labor. This is particularly true of principal-agent alignment and voice issues. Black notes that, "the Securities and Exchange Commission--sometimes intentionally, sometimes not--has been a principal purveyor of shareholder pacification." Other proposals necessitate Congressional action. Proposals for deregulation of voice fall into both categories.
Deregulation of voice proposals are directed at rules and legislation which restrict the ability of institutional investors to communicate with each other and with boards although their goal is not to control the firm. Rather they may wish to influence its policies.
Certainly the most important rule change in recent years was the 1992 SEC communication reforms initiated by CalPERS in 1989. The liberalization had significant impact on the ability of institutional investors to better coordinate formal and informal activities, and to more quietly influence boards of directors and top management. In Pound's words: "The new rules exempt communications by 'disinterested' parties--parties who are not actually soliciting votes--from the proxy statement filing and delivery requirements." However, few observers have been completely satisfied with the outcome. As Sharara and Hoke-Witherspoon note: "The SEC struck a balance between institutional investors' desire for unrestrained communication and management's desire to monitor backroom decision by large shareholders." Similarly Black writes the reforms were a 'middle range' between the original CalPERS proposals and the massive corporate lobbying against them in favor of the status quo. He calls for completing the "much work undone....with a view to further deregulating communications among shareholders." He notes that the 'political counterattack' by corporate lobbying groups such as the Business Roundtable may have stalled a reexamination of other reform proposals, as discussed below.
Since the 1992 liberalization one of the primary concerns is that the increased communication achieved can pose a threat to institutional investor voice in that they may now be considered a 'group', under Section 13(d) of the Securities Exchange Act of 1934. If determined that they are a 'voting group' they may become the subject of litigation brought by a 'target' company. A 'voting group' may be any number of institutions who jointly hold more than 5% of a firm's stock and courts determine to be acting jointly. Thus, increased communication without reform of 13(d) could potentially increase an institution's liability.
Given the potential new legal liability the liberalized communication rule opens many analysts have called for an explicit redefinition of control by the SEC. Coffee, for example, suggests that the current definition of control is overly broad and inherently vague. Securities Act Rule 405 defines control as the "possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities...or otherwise." This means the potential to influence control is sufficient to be considered 'control' itself. The authors of Lifting All Boats, following Coffee, Black and other legal scholars, propose what they term a 'safe harbor' rule which would explicit exempt institutional investors (or, alternately, certain institutional investors) from being 'controlling' by simple virtue of their attempts, for example, to monitor, and hence 'influence.' Similarly, the power to elect even a single board member may be considered control. Various reformers propose an increase in the shares a financial institution can hold to 10% or 15% without being consider a 'controlling person' or 'group' if they hold long-term and monitor. Thus the need for a 'safe harbor'.
Kester arrives at a similar conclusion although focused on contractual governance. He argues that the logic of increased vertical contractual governance, which he favors, logically leads to the commingling of debt and equity held by financial institutions which can and should consequently act as effective monitors. Thus, he calls for the "removal of existing impediments to the establishment of closer ties between the industrial and financial sectors..." Anti-trust law which limits vertical relations should be loosen while anti-trust legislation which limit horizontal competition is essential and should be maintained.
The authors of Lifting All Boats call for revision of the 1940 Investment Company Act so as to exclude from its provisions institutional investors who take a 'significant and stable' stake in firms, engage in monitoring, invest primarily in equities and hold for the long term. This would significantly deregulated current restrictions which limit investment companies to 100 investors. The reform would add yet another institutional 'voice' able to monitor.
While significant deregulatory proposals of voice are seen by many scholars as facilitating monitoring and relationship investing, so are regulatory proposals (as both incentives and disincentives) seen as necessary.
Coffee suggests there are insufficient incentives for money managers to exercise voice. This has two aspects: an information overload problem for large indexed funds; and, a problem of thin margins for money managers who sell indexing services to those funds. In turn, this leads them to cut costs and engage in price competition, thereby avoiding monitoring. Coffee proposes to remedy this by reducing the size of a typical indexed portfolio. Additionally he proposes making monitoring mandatory, including creating a market for the proxy adviser and creating a market for monitoring services by separating indexing services from monitoring services.
There is a structural and legal obstacle to this. Structurally large funds could then have huge blocks, and appear like German banks, which he believes politically undesirable. He therefore suggests an ownership cap of 3-5% in order to encourage institutional voice without control. Legally ERISA "mandates a unique and economically unsophisticated form of diversification... under section 1104a..." which focuses not on net loss, but on a potential loss of a 'sizable magnitude.' Thus, concentrated ownership is dangerous in terms of potential trustee liability. This should be reformed.
The authors of Lifting All Boats also argue that prudence needs to be redefined in terms of the "facts and circumstances of the process by which the portfolio is constructed." They note that the State of New York has already moved in this direction, and urge a similar reform of ERISA. Coffee and others also urge passage of a law that would either require or encourage institutions to retain voting power rather than creating trustee accounts.
Under the 1994 Department of Labor Interpretive Bulletin 94-1 (see Part IV) the duty to monitor, in Koppes' and Reilly's words, 'is subject to greater scrutiny' than previously. Koppes argues that the monitoring of delegates is inherent in the standards of prudence and that therefore the logic of the 1994 Bulletin is that a "new standard would impose a continuing duty to monitor prior investment decisions" not just current and future ones. He supports such interpretations by the courts. In this vein the authors of Lifting all Boats propose the SEC and relevant banking and state insurance regulators issue a 'statement of obligations' with respect to proxy voting similar to the DOL ones.
Disclosure and Democratization of Voting and Proxy Procedures
A major effort has been and is underway to reform various aspects of proxy voting procedures and the workings of key board of director committees, all with the aim of obtaining institutional voice, permitting freer flow of information to those wishing to exercise voice and assuring at least a minimum degree of independence of the board and its key committees from the potentially heavy hand of the CEO. Blair summarizes these proposals as being concerned with equal voting regardless of class of shares; limitation of powers of the board to impose changing terms of directors' appointments in order to protect shareholder rights; and, deciding elections on the basis of votes actually cast, rather than assuming unvoted proxies are in favor of management. Many of these proposals could be instituted by corporations themselves without changes in law, but some could not, and many advocates argue for national standards for best practices, thus requiring SEC and or Congressional action. More broadly, Blair cites a proposal for tying corporate democracy to relationship investing in order to reduce the adversarial quality often associated with interest group politics.
Coffee suggests that the power of incumbent management to manipulate the proxy agenda may need to be regulated, especially regarding corporate management's ability to bundle issues. (That is, for example, to offer shareholders a generous one-time dividend tied to a pro-management board revision or by-law restructuring.) As an alternative he proposes an unbundling strategy which would shift voting decisions from money managers to either specialized proxy advisers or to institutional investors having adequate in-house expertise. Such proposals would require SEC and/or Congressional action for further regulation.
The authors of Lifting all Boats call for improving access to the proxy statement by institutional investors by changing Section 14(a)(8) of the Securities Act of 1934 to make utilization of the proxy process less expensive. This section of the Act permits shareholders to use the corporation's proxy statement for some purpose but not for others. Especially prohibited is using the proxy statement in relation to election of officers. They propose that in order to make use of the proposed provision a floor of, for example, 10% of all shareholders be required to sign on to a proposal prior to submitting it to the general shareholder population. This would prevent tiny, minority shareholders from offering frivolous or nuisance proposals. Such reform would enable institutional holders to comment on individual board members up for election, and thereby raise substantive issues in a public manner. The Lifting All Boats authors also propose greater disclosure of information regarding the independence (or lack thereof) of nominating and auditing committee of boards of directors, under Section 14(a)(7) of the 1934 Securities Act.
If selective deregulation and further regulation of voice is seen as improving monitoring, similarly deregulation certain types of exit (improving the liquidity of the market) is taken by reformers as improving the ability to effectively monitor. Improved liquidity should also lower the cost of capital. The primary focus of these proposals has been on insider trading rules.
One likely consequence of deregulating of voice and consequently increasing monitoring would be the possibility of regular access to 'insider information' by the direct and indirect representatives of institutions. Trading on inside information is for short-term gain; long-term holders should have little interest in it. Currently there are complex regulations backed up by severe penalties which prohibit various forms of trading on inside information.
Coffee notes there is concern that deregulating exit might lead not only to greater insider trading but also to stock market manipulation. Thus, he proposed a reform of Section 16(b) that would create a safe harbor by exempting institutional investors who are not short-term traders. This would involve re-interpreting and loosening 'deputation theory' so that individual representatives of institutions could function on boards of directors or in other interactions with firms more effectively. He argues that the easiest solution would be to exempt from 16(b) rules trades made simply to maintain an indexed portfolio, which must be adjusted ('automatically') as the market changes to keep the index balanced. Such trades are not motivated by insider trading. The authors of Lifting all Boats also call for revision in Section 16(b)'s deputation theory which is concerned with exit.
While selective deregulation of exit is regarded as important some governance reformers would simultaneously restrict exit through either incentives for holding long-term or by disincentives for selling short-term.
Limit Voting Rights of Short-Term Holdings
Thurow, for example, would limit equity voting rights linked to the length of time held, e.g. one-third voting rights if held more than two years; two-thirds voting rights if held for four, etc. While contradicting some other reform proposals promoting liquidity (see above) Thurow's suggestion would orient voting toward long-term interests while creating a barrier to exit. The result would be that short term, liquid investors would have little or no influence on a company while long-term investors would be empowered.
Tax Incentive for Long-Term Holdings
Porter proposes tax incentives for long-term holding, especially reducing capital gains tax rates, and extending tax benefits to currently untaxed investors such as pension plans.
Reforms on the Corporate and Institutional Investor Level
A wide variety of reforms have been proposed by scholars and activists which do not require either changes in regulatory administrative rulings or in law. In varying degrees some of these have been implemented by corporations and institutional investors while others have not. Below we summarize some of the most important of these proposals.
Porter forcefully argues for expanding boards to reflect contractual representation of suppliers, customers, and of employees. Kester makes similar arguments for encouraging contractual governance systems as "close, vertical commercial relationships [which] can be sources of efficiency in contractual exchange."
Porter suggests that the stated mission of the firm should be the 'long-term shareholder value as [the] goal of firm rather than current stock price.' This would discourage short-term trading and promote long-term holding. He proposes a series of recommendations which would primarily encourage firms to seek out long-term owners, and to accept their role in governance. He also advocates changes in accounting practices to facilitate this.
There are numerous proposals for linking management remuneration to long-term performance, in particular by requiring managers to have direct, long-term and significant stakes in the firms. Others also encourage stake-in-the-firm proposals for lower-level management and employees through ESOPs and other employee stockholder devices, as discussed below.
Board of Directors: Representatives, Responsiveness and Democratization
Board of director reform proposals focus on greater accessibility to institutional owners, greater and more direct representation of institutional holders, and responsiveness to their policy concerns. While many proposal are complex the following illustrate some of the particulars:
confidential voting;
cumulative voting to ensure minority representation on the board;
availability of shareholder lists to all shareholders upon request;
designation by the board of an independent director or special committee to communicate with shareholders at company expense, in exchange for limitation of liability;
permit large shareholders direct representation on the board;
pay directors in stock in order to link long-term pay with long-term performance;
divide the role of CEO and chairman of the board;
reduce the size of boards;
limit number of seats on different boards a director can hold;
mandate that outside directors meet on a regular basis alone, without the CEO and other insider directors present;
mandate that an independent compensation and an independent nominating committee be composed only of truly independent directors;
alternatively, some critics see independent nominating and compensation committees as something to be avoided since they might not represent all shareholders equally, especially smaller shareholders.
As discussed in previous sections many analysts and activists have called for a significant reduction in average size of institutional portfolios without increases in risk in order to better monitor. Porter recommends creating special funds such as "relational investing funds" to test new investment approaches. In 1995 CalPERS established such a relational fund. Koppes and Reilly conclude that the problem for all public funds is over, not under diversification, and advocate a significant reduction in portfolios.
Professional or Institutional Directors
There has been a widespread discussion as to the merits and demerits of professional directors. Some reformers do not like the idea while others do. The basic idea is to confront the problem of 'who hold[s] real power in corporate governance...' in order to break the 'club ethos' of today's outside, yet only nominally independent directors who may function more independently in name than reality. Coffee argues that creating a market in professional directors is an adequate but limited response to the problem since without making the director financially dependent on the institutional owner rather than on the firm on whose board they sit an agent-principal problem is re-created. He argues this avoids aligning incentives at the institutional level, since all institutions have principal-agent problems themselves. Institutional managers may well be "rationally apathetic" given the free rider problems inhibiting institutional activism. Black proposed that institutions select an institutional representative(s) to the board. This could be done formally through a registry of directors, or the process could be more informal. Such a system would help permit minority board representation and also institutionalize voice. Black makes clear that his idea is not for public interest shareholders but rather for institutional representatives only. He suggests a careful study of the U.K.'s Promotion of Non-Executive Directors (PRO-NED) system. Monks argues for 'shareholder directors', a similar notion to Coffee's, and for the creation of professional directors' organizations, and for the development of a market for directors.
Align Managers Incentives Properly
Coffee and others (including changes CalPERS' made in its own internal incentive system) suggest formulating internal financial incentives systems to minimize principle-agent problem internal to institutional investors. There is a legal aspect to this since the Investment Company Act of 1940 restricts the linking of capital gains to managers compensation. This is especially a problem in a pension fund (rather than a mutual fund) since good performance will tend to expand a mutual fund's assets thereby increasing managers' compensation since it is typically linked to growth. This is not the case for investors such as pension funds whose goal is not growth but rather meeting defined obligations. Active monitoring of smaller portfolios should increase a fund's value, however, and this in turn could be linked to compensation.
Encourage Blockholder and Trade Groups
The logic of most of the analysts reviewed in Part IV is to encourage in formal and informal ways the growth of blockholders. Black, for example, suggests establishing so-called "white squire type" funds which would take substantial "relational" stakes in firms, perhaps coordinated by trade groups such as the Council of Institutional Investors, the Institutional Shareholders Service or activist consulting groups like Madison and Gordon Groups.
Monks suggests that one or more institutional monitors undertake primary responsibility for monitoring a particular firm as a lead monitor, and coordinate with other lead monitors joint activity and information sharing across broad portfolios. Various trade groups could serve as clearinghouses for such joint monitoring. Porter makes similar proposals.
A number of analysts have suggested that both public and private institutions should voluntarily disclose proxy voting and investment decisions on certain critical corporate matters such as takeovers, proxy contests, restructuring decisions and shareholder-rights plans as a condition for increased influence and power in firms. If they don't do so voluntarily, they should be required to do so.
Safe Guard Public Pension Funds
Romano proposes that public funds, who have been viewed by most observers as leading the 'corporate governance revolution', be as insulated from political pressures as possible. This would include:
ensuring membership on fund boards include elected representatives of fund beneficiaries;
applying ERISA standards to public funds;
constitutionalizing public funds' independence from political authorities (as happened in California in 1992);
shifting funds from defined benefit to defined contribution forms;
mandating passive strategies for portfolios.
In the corporate governance literature there are a number of other reform foci worthy of mention which do not fit neatly into the previous categories.
A number of proposals suggest a tax on stock trades for equities held short-term in order to minimize stock turnover and encourage longer-term holding.
As part of Porter's concern for restructuring the mission and strategy of firms, he offers a number of accounting concepts which would measure long-term value by standards other than current stock price, e.g. worker training and other human capital investments. In turn he argues that it is important to bring employees directly into governance by giving them some form of ownership stake.
Numerous critics and activists have been concerned with state-level governmental 'protection' of corporations through the sanctioning of poison pills, weighted voting and other anti-takeover measures. Thus, for example, Williamson argues for federal takeover legislation in order to override protectionist state legislation as well as for charter reform of individual corporations that write protectionist language in their charter provisions. Similarly, Monks argues for a 'Federal Law of Ownership' in order to prevent a state-level 'race to the bottom' for corporate charter protection provisions. He argues that the logic of the Department of Labor's 1994 reforms (requiring institutional investors to enhance the value of their shares through monitoring and other measures) is a uniform national corporate charter that will facilitate and encourage monitoring activities.
Monks argues the Department of Labor should be explicit in requiring ERISA trustees to act in the 'exclusive benefit of' and 'solely' in the interest of plan participants in monitoring which he suggests may 'spur the creation of special purpose fiduciary institutions in the future.'
ESOPs: Employee Stock Ownership Plans
As a final point it is worth noting that a number of scholars and policy analysts have argued that the growth in the last decade of Employee Stock Ownership Plans (ESOPs) should be seen as a potentially important factor in corporate governance debates. Logically they propose that both governmental and private sector policy actively encourage ESOP growth as well as making ESOPs directly representative of and responsive to employees, rather than management dominated and controlled as is often the case currently. Blair, Monks and the authors of Lifting All Boats in particular link governance reform proposals to giving employees a stake in the firm. They argue that data suggests this increases firm level productivity and provides a different yet important voice in governance, much like the dual tier boards of German firms aim at institutionalizing employee voice and interests. Blair and the authors of Lifting All Boats argue that as firm specific human capital increases in importance (for both the economy as a whole and for a firm's competitiveness) providing adequate incentive alignment for human capital is a critical part of governance reform. (See Part II)
The authors of Lifting All Boats, for example, strongly support various forms of 'enabling working people to share in the long-term growth of US equity markets [which] may help to mitigate the impact of declining real wages...', and in the aligning the interests of employees and shareholders as well as increasing firm productivity. Specifically, they suggest amending the tax code for ESOPs to take advantage of capital gains to a greater degree, and to guarantee full voting rights to employees in ESOPs by amending ERISA.
This review of recent and current policy proposals suggests there is a paradigm shift in corporate law underway which reflects the sea change that has occurred in the ownership of US publicly held corporations. The shift has not and is not likely to take place in a short period, but rather its large agenda will move in fits and starts in a number of venues over a long period of time. Indeed, it is clear that most of the reform proposals have not been adopted, and those few that have (most notably the 1992 communications liberalization) have themselves raised additional concerns and problems. The paradigm shift in corporate law and government policy underway is also reflected in policy changes and debates among institutional investors and corporate management, as various forms of new relations among these institutions develop in practice. While change in non-governmental, private sector policy has been more rapid than changes in law and regulatory rules, it, too, remains limited in scope.
In Part VI, the final section, we attempt to draw together the implications in of the sea change in ownership and changes in corporate and institutional investor activities and in government policy, and raise some questions which remain unanswered to date.